Diversifying reserves carries major risks, warns Taiwan governor

Perng Fai-nan points to the records of Norway and Singapore’s SWFs as a warning about diversification risks; blames SWF outsourcing to asset managers for exacerbating EM volatility
Perng Fai-nan
Kao Kuoen

The governor of the Central Bank of the Republic of China (Taiwan) has issued a warning to central banks about volatility risks and short-term losses that can be associated with a shift away from traditional reserve investments, such as US government or mortgage agency bonds.

Perng Fai-nan, whose central bank is armed with almost $450 billion of reserve assets, has had to fight off a number of leveraged, speculative attacks against the new Tawanese dollar during his term as governor, which started at the height of the Asian financial crisis and spans nearly two decades. As a result he is keenly aware of the value of being able to demonstrate he can draw on reserves when fending off currency and other speculators.

Asked during a Central Banking journal interview, to be published on October 3, about the value of diversifying central bank FX investments given the current low or even negative real returns from traditional reserve assets, Perng pointed to the increased volatility that can occur when alternatives are sought out. Notably, he cites the recent records of Government Investment Corporation (GIC) of Singapore and Norway’s Government Pension Fund, two of the world’s largest and most respected sovereign wealth funds (SWFs).  

[GIC’s] latest financial report shows that the annualised volatility of its investment is higher than the annualised nominal return across the five-, 10- or 20-year investment horizons (6.6%, 10.2% and 9.2% versus 5.1%, 4.3% and 5.7% respectively),” says Perng. “Moreover, extreme events, such as the financial crisis of 2008, can bring challenges to central banks and sovereign wealth funds. Take Norway’s Government Pension Fund, for example – its returns in 2006 and 2007 were 7.9% and 4.3% respectively. However, the global financial crisis lowered the rate of return in 2008 to negative 23%, with a loss exceeding $90 billion.”

Perng says these two cases “clearly show the trade-off between risk and return must be kept in mind”: “While the level of risk tolerance may vary, each central bank needs to optimise its portfolio asset allocation to balance safety, liquidity and return considerations in order to manage the reserves effectively.”

Perng says supranational and agency bonds with credit spreads “are good alternatives” for “enhancing the rate of return. And he adds that although the amount of negative-yielding sovereign debt rose sharply to a peak of $10 trillion in June 2017, “hawkish central bank rhetoric” has “cooled the bond market and led to broad-based reductions across the sub-zero-yielding landscape”.

“The amount of negative-yielding sovereign debt has come down to $8.7 trillion by mid-July. For the first time in the past year-and-a-half, negative yields offered by some developed countries have disappeared in the seven- to 10-year segment of the curve,” Perng adds.

Herding by asset managers

Perng also says the trend by ever-larger SWFs, whose total assets exceed $6.5 trillion according to some estimates, to outsource portfolio management to external asset management companies is exacerbating portfolio flow problems for emerging markets.

“Asset managers tend to engage in herding behaviour, where a group of managers rush to enter or exit one particular market at the same time,” says Perng. “This herding behaviour would cause the forex supply and demand curves to shift, resulting in market overshoots that disconnect exchange rates from economic fundamentals.”

Perng uses the case of Taiwan, South Korea and Singapore.

“Although economic fundamentals in these countries vary widely, exchange rates of the new Taiwan dollar, South Korean won, and Singapore dollar against the US dollar are highly correlated, as they are all similarly affected by short-term international capital flows. Stock indices in these three countries are also highly correlated. Short-term international capital movements are a major determinant of stock prices and exchange rates in several Asian countries.”

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